What is the purpose of IR35?
IR35 came into force on 6 April 2021 (it was due to take effect last April 2020 but was postponed until 6 April 2021 when the pandemic hit). IR35 is essentially shorthand for the UK anti-avoidance tax legislation implemented to ensure that “off payroll” workers are appropriately taxed.
In the UK there are 3 classifications relevant to individuals working for or providing services to a company:
- Employees who have employee income tax and employee National Insurance Contributions (NIC) deducted at source by their employer using the Pay As You Earn (PAYE) system. Employers also pay employers NICs.
- Workers who are normally contracted in some other way (whether directly or via an intermediary such as an agency or perhaps the worker’s own personal service company (PSC)) but still provide a personal service (i.e. self-employed individuals providing expertise who must provide the services themselves in a similar way to employees). Workers have some but not all employment rights.
- Independent contractors who are similar to workers but normally have less (or no) obligation to provide the service personally and can therefore send a substitute in their place. Independent contractors have few employment rights except the right to bring a discrimination claim.
How an individual is taxed differs depending on status. IR35 is concerned with the latter two categories who are not captured via PAYE. For the purpose of this note, we use the term “worker” to capture all individuals who are not employees.
Workers working directly (i.e. the contract is between the end user and the individual) will normally pay personal income tax via the annual HMRC self-assessment obligation. However, those working through intermediaries (i.e. the contract is between the end user and another entity to supply the services of an individual) may avoid being captured in such a way, possibly by paying themselves income from those personal service companies in dividends etc which attach different (and lower) tax levels.
HMRC already has a keen eye on those individuals working directly and declaring their income via self assessment etc for income tax purposes. IR35 is therefore concerned with unmasking those workers who work via intermediaries but for all other intents and purposes would essentially be regarded as employees. IR35 is designed to make sure that those workers who supply their services to clients via an intermediary but who would be employees if they were providing their services directly to the company pay broadly the same income tax and NICs as employees. Such workers are called “disguised employees” by HMRC.
An intermediary will usually be the worker’s PSC but may also be a partnership or another individual. A PSC is a type of intermediary where the worker has a material interest – meaning that they are either the director of the company or able to control more than 5% of the ordinary share capital of (directly or indirectly). The rules apply even if the worker is supplied via an agency but works through an intermediary – and no matter what your arrangement with the agency (i.e. however many indemnities etc you have in place), you, as the end user, are responsible.
Therefore, IR35 places responsibility on the “end user”, the company to whom the worker is providing services, to determine the appropriate status of the worker and ensure they are taxed accordingly. Status determination must not only be carried out on a contract by contract basis but is also ongoing. It will not be adequate to make a determination of status at the start of a relationship or even an individual contract and believe that this will suffice.
The off payroll working rules (including IR35) apply to both PSCs and to managed service companies (essentially a company structure designed to reduce the tax liabilities of the workers supplied by its directors and shareholders). So, if the Company engages in a contract for the provision of services and the individual providing those services operate via their own PSC or is a director or shareholder of the company with whom the Company is contracting, alarm bells should be ringing.
Potential penalties for non-compliance
As is so often the case, concerns around legislation are driven by the potential penalties for non -compliance. In the case of IR35, the end user will be liable for the PAYE tax and NICs looking back for up to 6 years unless a status determination statement (please see below) is produced with reasonable care and is passed to the intermediary and to the worker and any tax or NIC due are properly deducted and paid to HMRC.
Penalties will be applied on top of any back tax and NICs and can be considerable:
- A penalty of 30% of unpaid tax if HMRC determines that an end user was careless about employment status.
- A penalty of 70% of unpaid tax if HMRC determines that an end user knew that a worker was within IR35 but failed to act.
- If contractors do not calculate the deemed payment even after knowing they are inside IR35, and also make an attempt to hide the underpayment, the penalty is 100% of unpaid taxes.
Although the requirement to determine status remains, HMRC has said that businesses “will not have to pay penalties for inaccuracies in the first 12 months relating to the off-payroll working rules, regardless of when the inaccuracies are identified, unless there’s evidence of deliberate non -compliance”. Essentially provided a business that takes reasonable care to apply the off-payroll working rules correctly but still made a mistake, including making mistakes in status determinations, it will not be fined for the first year. So, in essence compliance is mandatory but HMRC will show some lenience where businesses try but make mistakes.
Is it the Company’s obligation as the “end user” to assess tax status and deduct tax etc if appropriate?
The Company, as the end user or client must determine whether, if the services were provided under a contract directly between the Company and the worker, the worker would be regarded as an employee for the purposes of PAYE or NICs and therefore is within IR35.
Having determined the worker’s deemed employment status, the Company must issue a Status Determination Statement (SDS) which sets out your determination in respect of the worker and also the reasons for reaching that determination. There is no prescribed format for the SDS but:
- The SDS must be given to the worker and the entity with which the Company as the client contracts. If you fail to do this the Company will be treated as the deemed employer. Therefore, it is essential that you have in place procedures for ensuring that a) the SDS is carried out and b) the SDS is communicated to the intermediary.
- The Company must take reasonable care in making its SDS. If you fail to do so, any SDS issued will not be valid and you will be treated as the deemed employer.
- For existing contracts, the SDS must be issued before the first payment under the contract on or after 6 April 2021. For new contracts, status should be determined before services are performed under the contract and, ideally, before the contract is signed since the deemed employment status is likely to affect negotiation of the fees payable.
If IR35 applies, the Company is obliged deduct tax, NICs and the Apprenticeship Levy if appropriate. The Company should also calculate a “deemed employment payment”. This is the amount deemed to be the income of the worker after statutory deductions and national insurance contributions have been removed. You will then need to do the following:
- Pay employer NIC to HMRC
- Pay any tax and employee NIC
- Take into account “deemed employment payment” when paying corporation tax.
Your tax advisers will be able to advise you on status, risks, the amounts to be deducted and appropriate tax obligations.
If IR35 applies you may wish to give careful consideration as to whether the worker should, in fact, be a full time, part time or temporary employee.
How do you assess status?
A worker’s employment status for tax purposes can be determined a number of ways, including using HMRC’s Check Employment Status for Tax tool (https://www.gov.uk/guidance/check-employment-status-for-tax) or any number of other tools on the market.
The advantage of CEST is that HMRC should stand by any determination properly made using the system. The disadvantage is that reports are that it is a fairly blunt instrument, asking only a limited number of questions to determine status, and therefore tends to capture most relationships that may be borderline. Other tools may provide a more nuanced determination but HMRC will not be bound by them. It is therefore worth researching any tool you plan to use carefully (they vary enormously in price and efficacy) to gain an understanding of how effective it is and the likelihood of any determination standing up in the event of an HMRC investigation or before a tax tribunal.
Many accountancy practices have their own tool and, as we mentioned on our call, we are aware of one client using a tool called “IR35 Shield” (https://www.ir35shield.co.uk/). They report that they have found it useful and having reviewed the free demonstration offered we did find it to be more nuanced than CEST. However, we must make it clear that we are not recommending this particular tool – we are not tax experts and do not have the expertise to analyse whether the tool is good or indeed right for you. We recommend that you seek independent advice from your own tax advisers.
Using Umbrella Companies
Following the introduction of IR35 rules in 2000 (which applied to the state sector rather than private companies) there was a surge in the creation of so called “umbrella companies”. These are companies that supply the services of workers but unlike PSCs or managed service companies they are operated by a third party who (in a true umbrella company) acts as the worker’s employer – providing the worker with employment rights such as holiday pay, and crucially from an IR35 perspective, deducting PAYE and NICs. Whilst umbrella companies may seem like a sensible (and often easy) solution, it is still vital that any company engaging workers in this way conducts appropriate due diligence. If the umbrella company fails (or never intended) to comply with its obligations to deduct tax and national insurance contributions, liability will still fall on the Company. If an umbrella company is used you must conduct appropriate due diligence, and critically should ask for appropriate proof that tax and NIC (employers and employee) are being deducted and paid to HMRC. It is also important to ensure that other employment obligations are being complied with, in order to minimise the risk of an individual claiming employee rights against you.
- Conduct appropriate due diligence on all contactors and undertake appropriate IR35 checks using CEST or another status determination tool and issue SDSs as appropriate.
- Review all contractor contracts and prepare a detailed schedule of contractors, terms, start and end dates, status determination, review dates etc. Implement an appropriate review schedule including point of engagement, point of each contract or schedule of work, and at regular intervals for any longer contract periods.
- Depending upon how many contractors are engaged, consider appointing someone responsible for engaging all off-payroll workers. This may prove to be a challenging appointment, as it will be that individual’s task to justify the arrangements to HMRC. However, it will hopefully mean that these arrangements will be carefully considered.
- Raise awareness within the business by conducting appropriate training on IR35 compliance, especially for managers responsible for recruitment, contract negotiations and onboarding.
- Consider the implementation of an IR35 compliance policy to raise awareness and help ensure compliance.
- Consider whether it is appropriate to impose blanket rules – some companies now operate a no contractors / no PSCs etc rule. Consider whether it is appropriate to only engage workers via appropriate umbrella companies – and subject those companies to appropriate due diligence.
- Determine what approach will be taken should a worker fall within IR35, for example will those individuals need to become employees? Will they be engaged via an umbrella company? Etc.
- Ensure there is an appropriate audit trail – one which demonstrates due diligence undertaken at all stages, how status has been determined, when, where and how SDSs have been issued, monitoring to ensure compliance etc.
- Make sure onboarding systems are updated to include due diligence, systems are put in place to include the process by which the SDSs are issued once determination has occurred.
- Review contracts with all third-party people suppliers (including PSCs, managed service companies, agencies etc) to ensure status (including whether they are an appropriate umbrella company) and appropriate contract terms.
- Ensure that in addition to reviewing contracts with PSCs etc all contracts with individuals are appropriate and include appropriate contract terms. Even where the individual is being supplied by a PSC or even an umbrella company you must still ensure that appropriate terms (including confidentiality etc) are in place directly with the worker providing the service.
When does IR35 not apply?
It is worth noting that at present (this may change) IR35 does not apply to “small” companies, defined as companies to which two out of the following three criteria apply: the annual turnover is not more than £10.2 million; the company’s balance sheet total is not more than £5.1 million; the company has no more than 50 employees. The turnover of parent companies, those based within and outside of the UK can be taken into account depending on circumstances – appropriate tax advice on the group structure should always be sought.
In the case of small companies (as defined by HMRC) the obligation to determine tax status still rests with the intermediary. That however does not get the end user company entirely “off the hook”. There will still be employment rights and potential tax risks associated with any ruling by HMRC that an individual does have employment status notwithstanding the arrangement. It is therefore worth status checking all contractors irrespective of company size to ensure compliance.
Equally IR35 does not apply if the individual contractor is not liable to UK tax. However, it will apply if the individual is subject to UK tax even if the PSC is based overseas.
Bottom line – unless you are absolutely satisfied that IR35 does not apply, assume that you should be complying to avoid the risk of penalties and reputational damage.
For more information, or to discuss further please simply request a call and we can consider the above in more detail.